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Investment Outlook

Resurgence In Earnings A Load of Hooey

This time last year the market was digesting the results of the Brexit vote and what impact, if any, it would have on the global economy. As was so often the case with the conventional wisdom last year, it was dead wrong. The EU did not crumble and the world did not tumble into recession. Indeed, the major markets, the big three in the US anyway, have gone on to record high-water marks. Of course, the buoyancy in the US stock market is based more on the belief (hope) that the Trump administration will get tax and healthcare reform and a major infrastructure (stimulus) package through Congress.There is a popular argument that the rise in US stocks has nothing to do with the promise of fiscal policy changes, but because of a resurgence in earnings. Let me be very clear on this subject, the so-called resurgence in earnings is a load of hooey. As has been the case going on several years now, the resurgence in earnings is simply a continuance of accounting sleight of hand, or financial engineering if you prefer.

Perhaps this is why the bond market hasn’t been on the same page as the stock market, as bond yields have remained relatively low. Clearly the Federal Reserve is bound and determined to keep increasing the Fed Funds rate, which the stock market seems okay with, but the long end of the yield curve has resisted, so far anyway, reacting to the increase of rates along the short end of the curve.

Flattening Yield Curve

The result is a flattening yield curve, with short rates moving higher, but long rates remaining relatively unchanged. If the yield curve continues to flatten, the concern is that it could end up inverting, meaning short rates are higher than long rates. Typically, that is a recipe for recession, which is the only thing the stock market fears besides rapidly rising interest rates. In short, this is something that needs to get straightened out, which I have no doubt will happen. What straightened out looks like however, remains to be seen.

Perhaps some straightening may be underway, as the yields on the 10 and 30-year Treasuries have moved 14 and 11 basis points higher respectively this week, a pretty decent move. This could be a short-term reaction to the recent tough talk by the heads of the major central banks, or it could be early signs of a shift in perception about yield levels by the bond market. Historically, June and July are where shifts take place in the bond market, so we’ll just have to keep an eye on it to see what happens.We may be seeing some straightening in the stock market as well though. Although the long-term uptrend remains in place, there has been a serious decline in upside momentum in the weekly indicators. Also, on a technical analysis intermediate basis, there are indications an ending pattern may be forming.

Since early June, the S&P 500 has been in a clearly defined trading range, which suggests distribution. Distribution, or selling, is a normal occurrence after a profitable run, which the market has obviously had. Distribution can lead to a correction, which is a decline of at least five percent from the high-water mark, or it can be a lesser amount that is nothing more than letting off a little steam.

And, to be clear, an ending pattern does not mean there is a looming bear market, simply a correction within the current primary trend.

Expectations of a Pro-Growth Trump Agenda

As with all primary trends, investor sentiment is of primary importance. Clearly the market has risen since the election on positive sentiment, based on expectations of a pro-growth Trump agenda and the Federal Reserve not moving too far too fast.Based on media accounts, the Trump agenda is either on life-support or moving along as planned. It all depends on where you get your news. As for the Fed and the other central banks, it appears that after years of threatening, an honest-to-goodness tightening regime may actually be in the works.To sum all this up, as sentiment goes, so goes the market.

As a value investor, I am looking for low prices and high dividend yields, something that has been in short supply for some time now. A decent correction could change all of that in a hurry, which from my perspective would be a welcome development. It is totally illogical, but investors are most bullish when prices are high and most bearish when prices are low. The stock market is the only place where folks are comfortable paying too much for something. I mean seriously, have you ever told a car dealer to let you know when the price rises on a car you wanted and then you would buy? Retailers must be dying of jealousy.

A share of stock represents ownership in a company, not a gambling chip or a lotto ticket. Accordingly, when you buy into a company you are buying into the return on investment you will receive from your ownership in that company. The return on investment is the dividends you receive while you own the shares and the capital gain you realize when you sell the shares. For the maximum return on investment then you must buy the shares when they offer the greatest upside potential with the lowest downside risk, which we call good value. Purchasing at less than good value lowers your potential return on investment and increases the potential for loss of capital. Yes Virginia, investing really is that simple. What is difficult is managing the emotions associated with investing. Fear and greed abound, patience and discipline are rare. For the value investor to be successful you must strive for the latter and resist the former.

No market goes up or down forever. At some point the market will correct and good values will become available. Your challenge will be to recognize when good value exists and then acquire it.Have a great Fourth of July. That is all, now soldier on.

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Performance data for the Investment Quality Trends model portfolio is compiled and maintained by the Hulbert Financial Digest, an independent third party.

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